Tag Archives: Terms of Trade

Why dearer oil impacts developing economies more.

It wasn’t long ago that $100 for a barrel of oil was the norm but with the advent of the shale market the production increased which depressed prices. It was felt that the flexibility of large scale shale production from the USA could act as a stabiliser to global oil prices.

Oil shocks – supply or demand?

Oil shocks are not all the same. They tend to be associated with supply issues caused by conflict or OPEC reducing daily production targets. In the case of an increase in global growth there is the demand side for oil which increases the price. However this doesn’t have a great effect as in such cases the rising cost of imported oil is offset by the increasing export revenue. However today’s increase has a bit of both:

Demand – global consumption has increased as the advanced economies recover after the GFC especially China
Supply – supply constraints in Venezuela from the economic crisis. Also tighter American sanctions on Iran and OPEC producers are not increasing supply with the higher price.

Higher oil prices do squeeze household budgets and therefore reduce demand. Lower prices are expected to act as a stimulus to consumer spending but it can also have negative effects on the petroleum industries.

Emerging economies the impact of higher oil prices

Oil importing emerging economies are badly impacted by higher oil prices:

  • Terms of trade deteriorate as the price of their imports rise relative to their exports
  • Exports pay for fewer imports = importers’ current-account deficits widen.
  • Normally this leads to a depreciation a a country’s currency which makes exports cheaper and imports more expensive.

However this is not the case today. World trade is slowing and with it manufacturing orders therefore higher oil prices make the current account worse which in turn depreciates the exchange rate. For emerging economies who have borrowed from other countries or organisations a weaker exchange rate intensifies the burden of dollar-denominated debt. Companies in emerging economies have borrowed large amounts of money being spurred on by very low interest rates but they earn income in the domestic currency but owe in dollars – a weaker exchange rate means they have to spend more of their local currency to pay off their debt. Therefore indebted borrowers feel the financial squeeze and may reduce investment and layoff workers.

Another problem for emerging economies, as well as higher oil prices, is that central banks are looking to tighten monetary policy (interest rates) with the chance of higher inflation.

Source: The Economist – Crude Awaking – September 29th 2018

New Zealand’s Terms of Trade – Milk Powder v Oil

The recent history of New Zealand’s terms of trade has been largely linked to dairy product export prices although in a longer-term context the price of imported oil has been paramount. Today we can see that the price of powdered milk (export) and the price of brent crude oil (import) are heading in the wrong directions. Powdered milk prices are falling and brent crude oil prices are rising which makes for an unfavourable terms of trade – see graph. This is not a good sign for the terms of trade which reached its peak in March this year.

What is the Terms of Trade.
The terms of trade index measures the value of a unit of exports in terms of the number of imports it can buy, or the purchasing power of our exports. This is similar to comparing the number of sheep exports that will buy a typical imported family car, from one time to another. The formula is:
Formula: Terms of Trade (TOT) =

Export Price Index (Px)           x   1000 (base year)
Import Price Index (Pm)

  • An increase in the TOT (e.g. from 1050 to 1200) is called “favourable”
  • A decrease in the TOT (e.g. from 1050 to 970) is called “unfavourable”

A “favourable” (increase) in the TOT may come about because the average:

– export price rose and import price stayed the same
– export prices rose faster than import prices
– export prices stayed the same and import prices fell
– export prices fell but import prices fell faster

The index number that results tells us whether merchandise export price movements have been favourable relative to import price movements. An increase in the terms of trade from 1000 to 1100 represents an increase in the purchasing power of our exports of 10% which means, other things being equal, we would be able to buy 10% more from overseas. As a country we would be wealthier. A decline in the terms of trade would result in the opposite situation.

Limitations of the Terms of Trade

Terms of trade calculations do not tell us about the volume of the countries’ exports, only relative changes between countries. To understand how a country’s social utility changes, it is necessary to consider changes in the volume of trade, changes in productivity and resource allocation, and changes in capital flows.

The price of exports from a country can be heavily influenced by the value of its currency, which can in turn be heavily influenced by the interest rate in that country. If the value of currency of a particular country is increased due to an increase in interest rate one can expect the terms of trade to improve. However this may not necessarily mean an improved standard of living for the country since an increase in the price of exports perceived by other nations will result in a lower volume of exports. As a result, exporters in the country may actually be struggling to sell their goods in the international market even though they are enjoying a (supposedly) high price. An example of this is the high export price suffered by New Zealand exporters since mid-2000 as a result of the historical mandate given to the Reserve Bank of New Zealand to control inflation.

In the real world of over 200 nations trading hundreds of thousands of products, terms of trade calculations can get very complex. Thus, the possibility of errors is significant.

Evaluation

  • A decline in the terms of trade is not necessarily a bad thing. For example, a decline in the terms of trade may occur due to a devaluation in the exchange rate. This devaluation may enable a country to regain competitiveness and increase the quantity of exports.
  • The impact of a decline in the terms of trade will depend on the elasticity of demand. If demand is elastic, the lower price of exports will cause a bigger % increase in demand.
  • Some Less Developed Countries (LDCs) have seen an improvement in terms of trade because of rising price of commodities and food post 2008. It is not always LDCs who see a decline in the terms of trade.
  • It is important to distinguish between a short term decline in terms of trade and a long term decline. A long term decline is more serious for reflecting a fall in living standards.

New Zealand's Terms of Trade

The recent history of New Zealand’s terms of trade has been largely linked to dairy product export prices although in a longer-term context the price of imported oil has been paramount. Furthermore the change in trading partners has also impacted on terms of trade e.g a rise of over 40 percent in the bilateral terms of trade with China and the volume of imports from China increasing by 400% since 2002.

Today New Zealand’s Terms of Trade rose 4.4% over the MarchNZ T of T quarter and this favorable movement is largely accounted for:

  • Lower oil prices and petroleum products prices fell by 24.3% for the quarter, nearly replicating the 25% fall in the previous quarter.
  • Global deflation continues with overall import prices at 30-year lows. Eight of nine main categories recorded falls over the quarter, and import prices excluding oil fell 1.4%.
  • Export prices were unchanged over the quarter, with a rise in dairy export prices cancelled out by a decrease in the price of meat exports.

What is the Terms of Trade.
The terms of trade index measures the value of a unit of exports in terms of the number of imports it can buy, or the purchasing power of our exports. This is similar to comparing the number of sheep exports that will buy a typical imported family car, from one time to another. The formula is:
Formula: Terms of Trade (TOT) =

Export Price Index (Px)           x   1000 (base year)
Import Price Index (Pm)

  • An increase in the TOT (e.g. from 1050 to 1200) is called “favourable”
  • A decrease in the TOT (e.g. from 1050 to 970) is called “unfavourable”

A “favourable” (increase) in the TOT may come about because the average:

– export price rose and import price stayed the same
– export prices rose faster than import prices
– export prices stayed the same and import prices fell
– export prices fell but import prices fell faster

The index number that results tells us whether merchandise export price movements have been favourable relative to import price movements. An increase in the terms of trade from 1000 to 1100 represents an increase in the purchasing power of our exports of 10% which means, other things being equal, we would be able to buy 10% more from overseas. As a country we would be wealthier. A decline in the terms of trade would result in the opposite situation.

Limitations of the Terms of Trade

Terms of trade calculations do not tell us about the volume of the countries’ exports, only relative changes between countries. To understand how a country’s social utility changes, it is necessary to consider changes in the volume of trade, changes in productivity and resource allocation, and changes in capital flows.

The price of exports from a country can be heavily influenced by the value of its currency, which can in turn be heavily influenced by the interest rate in that country. If the value of currency of a particular country is increased due to an increase in interest rate one can expect the terms of trade to improve. However this may not necessarily mean an improved standard of living for the country since an increase in the price of exports perceived by other nations will result in a lower volume of exports. As a result, exporters in the country may actually be struggling to sell their goods in the international market even though they are enjoying a (supposedly) high price. An example of this is the high export price suffered by New Zealand exporters since mid-2000 as a result of the historical mandate given to the Reserve Bank of New Zealand to control inflation.

In the real world of over 200 nations trading hundreds of thousands of products, terms of trade calculations can get very complex. Thus, the possibility of errors is significant.

Evaluation

  • A decline in the terms of trade is not necessarily a bad thing. For example, a decline in the terms of trade may occur due to a devaluation in the exchange rate. This devaluation may enable a country to regain competitiveness and increase the quantity of exports.
  • The impact of a decline in the terms of trade will depend on the elasticity of demand. If demand is elastic, the lower price of exports will cause a bigger % increase in demand.
  • Some Less Developed Countries (LDCs) have seen an improvement in terms of trade because of rising price of commodities and food post 2008. It is not always LDCs who see a decline in the terms of trade.
  • It is important to distinguish between a short term decline in terms of trade and a long term decline. A long term decline is more serious for reflecting a fall in living standards.

Source used: ASB Bank Economic Update

NZ Terms of Trade

Part of UNIT 4 in the AS level course concerns the Terms of Trade. The terms of trade index measures the value of a unit of exports in terms of the number of imports it can buy, or the purchasing power of our exports. This is similar to comparing the number of sheep exports that will buy a typical imported family car, from one time to another. The formula is:

Formula: TOT = Export Price Index / Import Price Index X 1000 (base year)

An increase in the TOT (e.g. from 1050 to 1200) is called “favourable”
A decrease in the TOT (e.g. from 1050 to 970) is called “unfavourable”

A “favourable” (increase) in the TOT may come about because the average:

– export price rose and import price stayed the same
– export prices rose faster than import prices
– export prices stayed the same and import prices fell
– export prices fell but import prices fell faster

Last week New Zealand’s Terms of Trade figures indicated a decline of 0.7 per cent to 1288 in the three months ended 30th September. Basically what happened over this period was that the fall in export prices was greater than the fall in import prices – export prices fell 4% and import prices fell 3.4%. This was in contrast to the June quarter where the index rose 2.4 per cent to a 37-year high.

Below is a graph showing a history of New Zealand’s the Terms of Trade. The spike in 1971 was due to high export prices especially in meat and other agricultural commodities but didn’t last that long.


Source: The NZ Economy – An Introduction

NZ’s Terms of Trade and the Dairy Sector

The Economist last week had an article on the strength of overseas demand for NZ’s dairy products which in turn has pushed up the terms of trade to a 37 year high – see graphic. Terms of trade is part of Unit 4 in the AS Level syllabus.

The terms of trade index measures the value of a unit of exports in terms of the number of imports it can buy, or the purchasing power of our exports. This is similar to comparing the number of sheep exports that will buy a typical imported family car, from one time to another.

The key points from the article:
– NZ is emulating Australia’s resource-driven strengths.
– April 2011 sees NZ’s biggest trade surplus in history – NZ$1.1 billion – 7% of GDP
– NZ accounts for 33% of world dairy exports – that is twice Saudi Arabia’s share of world oil exports.
– NZ will should look to move away from basic foodstuffs such as meat, milk and focus on processed food. In the supermarket NZ produce should move from the walls to the central aisles.